While 2020 was the best year for mortgage originators in almost 20 years, the stocks of the mortgage originators have disappointed. Over the past six months, all of the big originators have underperformed the S&P 500. Investors are pretty much unwilling to pay more than a single-digit multiple for these stocks, and many have price-to-earnings ratios below 5. Companies report great numbers, and the market just sort of yawns.
That's why it was surprising when Rocket (NYSE:RKT) was up 11% on earnings -- and a lot more since then. Assuming this isn't entirely because Rocket has captured the attention of the WallStreetBets Reddit group, what's going on?
Origination guidance is strong despite the huge jump in interest rates
Rocket reported full-year volume of $320 billion, which was a 121% increase from 2019's volume of $145 billion. Gain on sale margin (the difference between Rocket's sale price on the loan and what it gave the borrower) rose to 4.46%, which was up substantially from the 3.19% it earned in 2019. For the full year, revenues came in at $15.7 billion, while earnings before interest, taxes, depreciation, and amortization (EBITDA) jumped 472% to $11.1 billion.
In addition to the good earnings (which everyone expected), Rocket announced a special dividend of $1.11 per Class A common share that will be distributed in late March. The other thing that got investors' attention was the origination guidance of first-quarter closed loan volume of $98 billion to $103 billion. This is only a 5% decline from the fourth quarter, which is impressive in its own right given that the first quarter of the year is always seasonally slow for the mortgage banking industry. It is even more impressive given the huge increase in interest rates over the past month.
The guided volume is 94% higher than Q1 2020, so Rocket sees the mortgage party continuing for a while. The other good news was the margin guidance, which is expected to come in at 3.6% to 3.9%, higher than the 3.25% margins Rocket earned in Q1 2020. So while the market seems convinced that 2020 was a one-time event, Rocket's guidance indicates that the momentum is carrying over into 2021.
The mortgage bankers haven't received much love from investors
The mortgage bankers have been disappointments, at least as far as their stocks are concerned. Even with Rocket's 10% move on the earnings announcement, it is still underperforming the S&P 500 over the past six months. PennyMac Financial Services and Guild Holdings have underperformed as well. Needless to say the recent trading activity in Rocket has erased all of this underperformance. That said, the sector is still underperforming.
While the 10-year bond yield has risen substantially since the beginning of the year, mortgage rates have risen much less. As Rocket mentioned on the earnings conference call, the Fed is buying 95% of all conforming mortgage production. The Fed clearly wants to keep mortgage rates as low as possible, and this makes sense in terms of its mission to support the economy. Allowing a borrower to refinance a mortgage and shave $50 or $100 a month off the payment is the gift that keeps on giving, with respect to economic stimulus. Second, this can happen immediately, without any needed legislation. The Fed wants mortgage rates low, and that is why they have risen much less than the 10-year bond yield.
More than just mortgages
Rocket is also much more than just a mortgage company. While mortgages are the main business, Rocket Auto (the company's auto marketplace) sold $750 million worth of cars and generated $107 million in auto loans. Rocket Homes generated $1.6 billion of sales in the fourth quarter as well. These ancillary businesses will help Rocket diversify its income stream against the feast-or-famine realities of the mortgage business.
Rocket is expected to earn $2.23 per share in 2021, which is a substantial decrease from the $4.11 adjusted earnings per share it earned in 2020. If the Fed keeps mortgage rates low, there is enough pent-up demand for mortgage refinances that 2021 could be almost as good as 2020 was. Don't forget, Rocket is paying a $1.11 special dividend and has a $1 billion share buyback (although it hasn't bought back any stock yet).
While the increase in the 10-year bond yield has been a damper on the mortgage sector, bond bears who are seeing rate hikes in 2022 and 2023 might get a reality check in two weeks when the Fed has its March Federal Open Market Committee (FOMC) meeting and updates the "dot plot." As of the December meeting, the Fed saw no rate hikes through 2023. If the Fed confirms this view and sees minimal rate hikes in 2024, then we could see a retracement in bond yields.
What is the right multiple?
If mortgage rates remain around current levels, 2021 will be another blockbuster year for the mortgage sector and the Street's current $2.23 estimate for Rocket is way too low. Now, the big question is what is the sector worth?
Unfortunately, mortgage bankers tend to have lower multiples due to the extreme cyclicality of the business. This is why they generally trade with mid single-digit P/E ratios. But think about the other businesses. Ally Financial trades at a 10 multiple. JPMorgan Chase trades at 14 times estimated 2021 earnings per share. Financial stocks generally don't command big multiples.
Rocket's investment in the Rocket App does make it more than just a plain-vanilla originator. There is a fintech angle to the stock that could make it command a higher multiple. Rocket has been one of my CAPS picks since the company went public. The tech aspect was a big reason for that.
As of Wednesday morning, when Rocket's stock was down 20% from Tuesday's spike but still far above its previous price, it was trading around 15 times expected 2021 earnings per share. That multiple would be too high for a financial if I thought the estimate was accurate. I don't -- I think it is much too low. If Rocket earns what it made last year, it is trading at 8.3 times, which is not rich for a financial stock, let alone one with some tech upside.